Restructuring of the Jingmei Hospital Challenged the Fundamentals of China Resources Phoenix Healthcare

HONG KONG, July 31, 2018 - (ACN Newswire) - Lately, China Resources Phoenix Healthcare or CR Phoenix (01515.HK) released a public announcement to participate in the restructuring of Beijing Jingmei Group General Hospital and its subordinate medical or elderly care institutions (collectively, "Jingmei Hospital"). Jingmei Hospital is a flagship hospital managed by CR Phoenix under its premier IOT model (Investment-Operation-Transfer), a principal business model of CR Phoenix, by which CR Phoenix usually manages those not-for-profit hospital without obtaining the hospital ownership. The restructuring of Jingmei Hospital aroused great concern within Chinese healthcare industry and is expected to generate substantial effects on development of IOT model in the new policy environment.

A Brief History of Jingmei Hospital

Jingmei Hosptial is one of the largest not-for-profit medical centers in the western suburban area of Beijing Metropolitan. In May 2011, Phoenix Healthcare (predecessor of CR Phoenix) and Beijing Jingmei Group Co. Ltd. ("Jingmei Group") concluded an agreement on investment and management of Beijing Jingmei Group General Hospital and supplementary agreements after rounds of discussions, marking the accession of Jingmei Hospital to the hospital management system of CR Phoenix through the IOT model originated by CR Phoenix in early 2010s.

In the current IOT model, CR Phoenix has the absolute power of business management or control over Jingmei Hospital, capable of implementing daily operation management in all respects, and charges a performance-based management fee. Besides, CR Phoenix gains supply chain earnings by control over procurement of such medical materials as drugs and consumables on behalf of Jingmei Hospital.

A lot of progress has taken place after Jingmei Hospital entered into the management system of Phoenix Healthcare, as what is referred to in the announcement of CR Phoenix: the hospital's revenue has kept a rapid growth and comprehensive quality standards have been remarkably improved, indicating that the IOT model, as an alternative solution to public hospital restructuring, has achieved tremendous staged success. However, the IOT model is not the end of the game. As planned by the former Phoenix Healthcare leaders, each hospital managed under the IOT model should eventually evolve to become an owned for-profit hospital with a clear and compliant business model (understanding that IOT is often questioned by its excessive profits extraction practices from not-for-profit hospital in terms of management fees and supply chain profits).

Moreover, recent tightened policies have also revamped the landscape for the IOT model. In the middle of this, CR Phoenix released an announcement on July 20: CR Healthcare Investment (China) Co. Ltd., a subsidiary of CR Phoenix, Jingmei Group and China Reform Guotong (Zhejiang) Investment Fund Partnership ("China Reform Guotong"), a state-owned subsidies fund, entered into a framework agreement, according to which the three parties will form a joint venture as the sponsor company to restructure Jingmei Hospital and the sponsor company will serve as the sponsor (owner of a not-for-profit entity) of Jingmei Hospital, which remains its not-for-profit nature. Upon the restructuring, Jingmei Group shall hold 40% of equity of the sponsor company and serve as the largest shareholder; CR Phoenix and China Reform Guotong shall separately hold 35% and 25% of equity in the sponsor company. In addition, the above three parties shall form a hospital management company to implement operation management on Jingmei Hospital. This model will replace the current IOT model of Jingmei Hospital (also replacing the hospital manager from CR Phoenix to the hospital management company jointly held by the above three parties). The announcement refers to this restructuring as "transition from the IOT model to sponsorship right model" and elaborates on benefits of restructuring of Jingmei Hospital at great length.

Doubts on the Restructuring of Jingmei Hospital

By a quick comparison between the two models, it seems that CR Phoenix gets no benefit in hospital operation by agreeing the new model:

Doubt one: CR Phoenix may lose control over Jingmei Hospital

The IOT model is mainly concerned with gaining the power of business management or control over a hospital through agreed contractual arrangement given that the hospital's ownership not being altered. Only by gaining the control over the hospital can one effectively run and manage the hospital, promote its operation efficiency and hence earn in real means, on which the success of the IOT model is based. Under the current IOT model, Jingmei Hospital is completely controlled and managed by CR Phoenix; whereas, upon this restructuring, Jingmei Group will reserve its position as the largest shareholder in the sponsor company and even get involved in the hospital's operation management through the management company. In view of the current equity ratio of the sponsor company and pending equity structure of the management company, CR Phoenix shall find it difficult to continue to deploy complete control over operation and management of Jingmei Hospital under the new sponsorship right model. In other words, CR Phoenix might be deprived from the foundation for creating benefits as a hospital manager.

Doubt two: Restructuring may have a substantial negative impact on the financials of CR Phoenix

Before the restructuring, the hospital's operating results exclusively belong to CR Phoenix under the IOT model; whereas, the restructured sponsorship right model shall require such profits to be shared by three parties, indicating that CR Phoenix may lose as high as 65% of profits in the hospital. It is a large sum indeed. According to financial data disclosed in the 2017 Report of CR Phoenix, it is estimated that Jingmei Hospital contributed around RMB 100 - 150 million (management fees plus supply chain profit) to CR Phoenix's entire profits in 2017, accounting for one third of total profits in the year. By ballpark estimates, CR Phoenix will need to pay as much as RMB 100 million every year as consideration for the restructuring, which may have a material negative impact on the total profits as well as valuation basis of the listed company.

Hence, except for minority interest in the sponsor company of the non-profit hospital, this deal does not bring any other actual "benefit" for CR Phoenix and even threats its control over its core assets -- Jingmei Hospital and will result in direct economic loss. Why did CR Phoenix agree to this unfair "deal"? Does it to do so on purpose or does it have no choice but to accept such requests from Jingmei Group? Is there anything in the shadow?

In doubt, something stands out in the review of previous announcements of CR Phoenix...

Restructuring of Jingmei Hospital in 2014

It is found in review of announcements of CR Phoenix that restructuring of Jingmei Hospital is not something new. In December 2014, Phoenix Healthcare (predecessor of CR Phoenix) announced to enter into a cooperation framework agreement with Jingmei Group, according to which, the two contracting parties agreed to found a joint venture to restructure Jingmei Hospital as a whole and enable the hospital to become a for-profit hospital and CR Phoenix and Jingmei Group would separately hold 70% and 30% of equity in the joint venture. Upon the completion of restructuring, the former IOT agreement between CR Phoenix and Jingmei Group would be no longer in effect.

It's no doubts that the 2014 version of the restructuring plan of Jingmei Hospital obviously favors CR Phoenix far more than the current version. First of all, the 2014 version directly restructured the hospital to a for-profit hospital, which is a radical advancement into a well-defined and compliant hospital business model to greatly enhance the hospital's value as originally planned in designing the IOT model; Secondly, upon restructuring, CR Phoenix became the absolute majority shareholder of Jingmei Hospital while Jingmei Group basically had no say in the daily operation.

The hospital's financials were incorporated into the consolidated statements of the listed company and it was no longer necessary to separately found a hospital management company to extract profits in terms of problematic management fees and supply chain profits.

At present, however, after the aggressive CR Group (controlling shareholder of CR Phoenix) steps in, the current version of restructuring of Jingmei Hospital shows an astonishing downside compared with the 2014 version, which fails to accomplish the two outcome in the 2014 version: for-profit hospital restructuring and absolute control over hospital operation (equity ratio is a half lower than the 70% in the 2014 version). Upon the completion of current restructuring, Jingmei Group will remain the single largest shareholder and even directly get involved in business management of Jingmei Hospital through hospital management company - which is the last thing a smoothly-ran IOT model wants to see. By the way, bear in mind that CR Group has no precedent that it is not a controlling shareholder in a hospital restructuring.

Thus, it seems likely that restructuring of Jingmei Hospital is not a negotiated outcome but CR Phoenix must be forced to accept the restructuring plan for some reasons.

Jingmei Group is the Big Winner

Why did CR Phoenix compromise for its successful IOT contract? In history, Jingmei Group is more "closely associated" with Jingmei Hospital than CR Phoenix is, but Jingmei Group's greatest bargaining power seems to be the innate defect of the IOT model--the uncertainty in the legitimacy of the IOT model, in particular brought by the recent policies.

Who is Jingmei Group? In the wake of the decline of the coal industry, Jingmei Group, a one time-honored mining state-owned enterprise in Beijing, has kept trying strategic transformation and as far as medical and elderly care industry is concerned, Jingmei Group has the advantage of many inherent resources like Jingmei Hospital and vocational healthcare facilities, and everyone knows that healthcare is a rising industry. If Jingmei Group decides to concentrate on the healthcare industry and makes full use of its existing healthcare resources to transform, expand and strengthen its healthcare industry in development, its move of taking back control over the fat profit Jingmei Hospital from CR Phoenix is well justified.

Unfortunately to CR Phoenix, that is true. Jingmei Group decides to evolve into a foe in the healthcare field but it also does not want to openly fight with CR Phoenix, another state-controlled company. According to coverage of Sohu Health (health.sohu.com) in June 2018, Jingmei Group convened a meeting on the Kengmuchang Branch Hospital (a rehabilitation hospital of Jingmei Hospital), declaring medical and elderly care industry to be a key development industry of Jingmei Group in transformation and reform. In furtherance, "based on the objective of building a Grade III Class A hospital and general strategy of Jingmei Hospital, project planning and design shall integrate healthcare resources in the Group including partnering CR Phoenix to reduce the following operation and maintenance cost in the rehabilitation hospital and guarantee maximum investment benefit of the new hospital with effort," said a senior leader from Jingmei Group. In order to achieve this, they need an excuse and an elaborated structure.

It turns out that Jingmei Group has successfully taken advantage of the weakness of the IOT model and threats to withdraw from the IOT contract should CR Phoenix turn down the elaborated three-party proposal: establishing a joint venture sponsor company and hospital management company through cooperation of three parties to take back powers of business management and control of Jingmei Hospital previously transferred to CR Phoenix through the IOT contacts, and lay out a channel for gaining hospital earnings, in the meanwhile, introducing a third party financial investor for funds rather than continuing to ask for funds from CR Phoenix. In light of the subtle role of China Reform Guotong, Jingmei Group is getting rid of control of CR Phoenix and gaining as much economic benefit as possible. In the end, it seems Jingmei Group not only escaped the IOT contracts by rendering a minority interest the sponsorship without changing the not-for-profit nature, but recaptured certain control over the Jingmei Hospital by becoming a permanent member of the hospital management company, which is totally unacceptable in the spirits of IOT modal, but this elaborated three-party arrangement did set up a platform in case that Jingmei Group would like to engage in healthcare business independently.

Where will the IOT Model Go in the Future?

As evidenced by the derailed changes in the restructuring of the Jingmei Hospital, the certainty and sustainability of the IOT model is once again under challenge, probably the most serious one since its debut - the termination costs are minimal compared with the huge economic interests taken away by the IOT contract.

In the first place, after years' trial and adjustments, national policies and laws have kept tightening, for example, Basic Healthcare Promotion Law (Draft) has strictly restricted non-profit hospitals from distributing any profits in any disguised form to its owner/sponsor or seeking any profits through a controlled supply procurement, which provides the IOT hospital another excuse to claim the IOT contract void. Secondly, in this March, CR Phoenix "came into a conflict" with Beijing Yanhua Hospital, another core hospital managed under the IOT model, due to excessive illegal profits made from the supply chain agreement and in this case, Yanhua hospital has threatened to terminate the supply chain management contract. Actually, Jingmei Hospital and Yanhua Hospital are the most important two IOT hospitals in CR Phoenix's system and contribute to more than half of the profits of CR Phoenix. Under such pressures, imaging that once Jingmei Group threatens to terminate the IOT contract by law or by contract (very little liquidated damages), CR Phoenix will have no choice but to accept the restructuring plan to avoid more severe economic loss - a total crackdown of the IOT contract.

Facing stress both inside and outside, the IOT model is experiencing its biggest challenge as to its certainty and sustainability. In this regard, CR Phoenix pops up the "prescription" that "transition from the IOT model to sponsorship right model", which is the outcome of no-choice. As discussed, the Jingmei Hospital restructuring case is not a good start, with too much control and profits being compromised by this restructuring. If this pattern continues or is followed by other IOT member hospitals, the successful and profitable IOT model will come to an end and the fundamentals of CR Phoenix will be at great risk (IOT hospitals contribute to more than 75% profits of CR Phoenix).

Maybe it is a bit overly worried but at current stage, but restructuring of Jingmei Hospital is not promising, and will increase volatility of CR Phoenix stock price.